Thursday, May 31, 2007

I had looked at Prosper some time ago, and decided not to lend money there at that time for the following reasons:

The advertised high interest rates are for the lowest-rated, riskiest borrowers and the forum told tales of defaults so it seemed unlikely to net a significantly high return (lend to 2 people at 25%, 1 of them defaults with the first due date, so you average a loss at -37.5%).

You have to win the loan by bidding down against rival lenders so it seemed unlikely to net high rates with the highest-rated, reliable borrowers—yet there is always a chance that even an A-rated borrower might default.

To diversify to hedge risk would require many hours of work to bid small amounts to many borrowers (you can lend $50 to a person who is seeking $5,000 in loans from many lenders).

Bidding means that you might waste time in research with no result and 0% interest.

I know that some lenders will beat the odds but I suspected that lending at Prosper would require much work, time, management, stress, and risk but with an uninspiring probability that it would not significantly outperform an FDIC-insured 5% Money Market/CD account or moderate-risk stock index fund.

Please share your experience if you have used Prosper or a similar service.

Complete the Prosper motto: "Where people come together to . . ."

Update 6/1/07:

Time: 2 timesavers are (1) you can set criteria and Prosper will auto-fund loans from your account, and (2) you are not allowed to be your own collection agency (this means that either the money gets repaid or it doesn't).

Update 6/21/07: You cannot cash out whenever you want as you could do with a money market. You cannot cash out early with a penalty as you could do with a CD. You must collect a few dollars per month and wait 3 years (a common loan term) to claim your full profit, if any.

Update 6/23/07:My Personal Finance Blog is pulling out of Prosper. Another point that new Prosper lenders might overlook is that "no defaults yet" after a year does not mean much because you might need 2 years just to get your principal back when I imagine that debtors are getting bored of paying and the luster of their vacation/wedding/business-that-did-not-take-off is long forgotten.

Update 6/25/07:My Money Blog posted data which so far support my 6/23 concern that defaults will increase over time.

It is always a good idea to go to the original report and check the “methodology” section, often buried in the footnotes, to see how the report created the results.

We start with Pew’s own numbers:

Real Income of Men Age 30-39

1964 $31,0971974 $40,2101984 Missing1994 $32,8012004 $35,010

The “falling behind” media headlines highlight the 2004 v. 1974 comparison but comparing 2 isolated data points is notoriously dangerous and you can see even from the short chronology above that the long-term trend shows an increase while 1974 is an “outlier” (aberration that deviates from the trend). The 1994 figure is also lower than 1974 even though during the 1990s the media told us ad nauseum how the 1990s was the greatest economy in history. The 2004 figure is higher than the 1994 figure so why isn’t the current decade greater than the greatest?

The “falling behind” media headlines highlight the comparison to a 1974 baseline but 1970s baselines are frequently misleading. If you ever want to “prove” decline, the 1970s is a good place to shop because of a peculiar set of economic convergences at that time. The numbers often appear to show the 1970s as a worker’s paradise even though this was the Archie Bunker decade of stagflation, an energy crisis, price controls, gas rationing, and a high Misery Index.

The report calculates income oddly, considering the topic of economic progress. The report’s idea of “income” excludes non-cash employer-provided benefits such as health insurance and retirement benefits but it does count government welfare checks. In other words, if your dad collected a lot of welfare, the report counts that as doing well. In Pew’s world, being on the dole is better than having health insurance or a pension.

The report has much more to question (a 30-year generation instead of a 20-year generation, the international comparisons, etc.) so feel free to see for yourself and post comments.

Sunday, May 27, 2007

Financial security or financial independence or being independently wealthy ultimately means being able to pay your bills without working. This might seem like a fantasy for people who today are behind the eightball but almost anyone should be able to achieve financial independence by taking one achievable step at a time (the sequence is not exact and steps can overlap):

Stop the negative savings (reach the breakeven point of income=outgo).

Pay off all debts.

Build a financial buffer (have a week’s expenses set aside, then 2 weeks’, then a month’s, etc.). Do not stop when you have reached the “standard” 3-6-month buffer in savings. Keep going and extend how long you could go without “standard” income. You are on the right track when you can measure your buffer in years. After all, many people plan for a decades-long vacation and call it “retirement” but ignore the artificial barrier of “retirement age” and “retirement accounts.” Eventually, your buffer will extend into your golden years.

Minimize and eliminate the need for active income (going to work)—although it is smart to work more than you need to build your savings. Meanwhile, use the resulting savings to build passive income (interest), although remember that future interest income is uncertain, such as a few years ago when the Federal Reserve slashed rates. You will be fairly comfortable if current passive income meets current regular expenses and you have the principal for emergencies. Although nothing is 100% certain, accumulate wages and interest into a lump of principal that will cover a lifetime’s expenses.

You generally have more control over decreasing your spending than you do over increasing your income, so lower spending is the best way to give yourself a raise.

Minimize Fixed Overhead, the 800lb Gorilla

The most important way to lower expenditures is to minimize your fixed overhead, i.e. regular expenses. Housing might be necessary but your current housing cost might not be necessary. Utilities might be necessary but your current cable and cellphone plans might not be necessary.

The magic part: lower spending (1) creates wealth and (2) reduces the need for wealth at the same time

Minimizing expenses is your most powerful tool because it has a double benefit and creates a virtuous cycle: Lower costs this year to increase your savings this year, so next year you have higher savings against the continued lower costs, so your financial buffer will last even longer if you do have an emergency. This type of “compounding” is as good or better than compound interest, especially since you pay taxes on interest earned but you do not pay taxes on money not spent.

Five Cent Nickel's recent post shows that he and the rest of the buck-o-sphere (personal finance blogging) are still crackling over net worth and practical wealth so here is further elaboration of my thinking:

Income (general): Any income recommendation such as “80% of pre-retirement income” is nearly worthless because it ignores expenses (costs/outgo)—and expenses are the whole reason that you need income.

Gross Income: Guidelines about what percentage of gross income to spend on Item X are nearly worthless because (1) taxes and deductions vary widely so net income varies widely, and (2) the value of “$100” of Item X can vary greatly by how much is asset value versus interest or related fees.

Net income: Even “25% of net income” for Item X can mean very different things to different people depending upon other regular bills (medical costs, etc.). Further, income can vary and future income is less certain than past income (savings are your residual past incomes).

What to measure:

Financial security = liquid wealth divided by total expensese.g., divide by monthly expenses to see how many months you can go without income.Remember to amortize infrequent expenditures (automobile purchase) into a monthly budget.

Expenditures are key

The critical value is your minimum necessary expenses, relative to available wealth (i.e. savings, not income). In other words, compare past surplus income to future costs; past income v. future outgo. You want to maximize your past, surplus, accessible income (savings/liquid wealth) and minimize your expenses.

Sunday, May 13, 2007

"Practical Wealth V. Phantom Wealth" covered how to measure your financial wealth accurately by accounting for liquidity and stickiness (resistance to change). This article now covers how people reduce their liquidity without realizing it.

Consumerism Alchemy: Turning Assets into Consumption

Most people realize that some assets such as cars depreciate and the depreciation supposedly represents the consumption or usage of the asset in wear-and-tear. However, many people then assume that any retained or core value at any point in time is a positive asset (often for their supposed "net worth")--but people often behave in ways that turns an asset into additional ongoing consumption.

2 ways in which "retained" asset-value becomes consumption:

The Resale Value Trap: Resale value is an "entry fee" surcharge and should be kept as low as possible. Resale value is a marketing trick to encourage overbuying. Never trading down (liquidating an expensive asset and buying a cheaper one) means that any core value is consumption, an expenditure never to be recouped. Some people fool themselves into thinking that they pay for car depreciation but “keep” the resale value, which is untrue, practically speaking. If you continually trade-in cars when they reach $10k value, that $10k (plus any interest) is forever lost as permanent consumption, an "entry fee" for "getting in the game."

The Emotional Attachment Trap: Emotional attachment is a form of illiquid stickiness that turns an asset into ongoing consumption. Count your car only if you are willing to trade it for a junker. Otherwise, it is phantom wealth because you would never tap it. Instead of disaggregating the value of basic transportation from surplus conveniences (CD player, etc.), you are treating the whole, indivisible car as psychic consumption. Do not count your grandmother's wedding ring if you would never sell it despite defaulting on your mortgage.

"Biggest Net Worth Mistakes: Is Your Net Worth Accurate or Useful?" covered how "net worth" and assets can trick you into the illusion of financial health (phantom wealth). Instead of net worth, use realistic measures of accessible wealth to rate your fiscal health. Too many people ask the "How much?" question but forget the crucial "When?" question.

Liquidity: WHEN you have money is as crucial as HOW MUCH.

Try calculating your wealth in the standard money measurements of liquidity to measure how much buying power you actually have at different time horizons, from immediately through the medium and long terms: Make your own personal M0 (“M zero”), M1, M2, and M3:

M0 = Cash.

M1 = M0 + checking or other “demand” accounts.

M2 = M1 + savings accounts up to and including insured CDs (

M3 = All money.

Compare cash with obligations at each time horizon (week, month, year, before age 59 1/2, etc.--including any withdrawal penalties). What if you lose your job, get sick, wreck your car, or have a house fire? You should have cash for small or likely or short-term events, scheduled liquidity for medium-term events, and use available credit or insurance only for the biggest, unexpected, unaffordable events.

Working Capital a.k.a. Operating Capital

Current Ratio = current assets divided by current liabilities

"Current" means liquid, liquidatable, or due within a time period. A potential pitfall is that, with a time period such as "this year," current assets include expectations of future income: Beware of relying on Accounts Receivable, including future wage paychecks, because they are not "a bird in the hand." If you have been opting for overtime pay recently, that precedent is no guarantee that you always will be able to choose your take-home dollar amount. Do not count your chickens before they are hatched.

Liquidity Ratio = liquid assets divided by expensesAssume your income suddenly becomes $0. How long would you last? A typical recommendation is a 3-6 month buffer, and the self-employed or irregularly-employed are more likely to keep even bigger buffers for longer lean times.

Accurately Rate the Liquidity of Your Non-Money Assets

Rate the realistic time horizon for liquidating the asset (Week? Month? Year?) before you include it in your appropriate "time horizon" assessment of wealth.

Be very cautious in counting non-money assets because their ownership is "sticky" (resistant to change). The stickiness might be due to legalities such as a car title, or regulations such as car inspection (it is grandfathered but would fail a new inspection), or transfer costs such as a sales tax. Both time-to-sell and sales-price can change with events, such as a CNN expose on how your car model is a death trap.

Tuesday, May 8, 2007

Deborah Beatty has no job but took a mortgage for a new New Jersey 3-story home with a view of the Manhattan skyline and Statue of Liberty and then did not pay the payments. Her daughter makes less than $20k/yr as a graduate student but took a $600k mortgage split into 8.75% and 12.5% interest rates and then did not pay the $5k/mo payments—maybe because the payments were more than 3 times (300%) her entire gross income.

Monday, May 7, 2007

So many people imitate the most popular but unhealthy ways of finance that it is important to know the full range of possibilities in order to make an informed decision. Here is a parable of a hypothetical Jack and Jill.

How to drop out of high school and pay cash for a house at 21 years old (legally and honestly)

Jack drops out of school at 16 and gets a GED by taking the test. He gets entry-level jobs totaling a modest 60 hours per week (still time to take a community-college course) and $25k per year. Living at his parents' home with free room and board (as a normal teenager would do anyway), it is possible to save $15k per year and still keep some pocket money. An after-tax 5% interest rate compounds to about $100k while age 21, mostly before he is old enough to legally drink his paycheck at bars.

Jack can buy a $100k home in cash, or marry Jill who did the same plan so they can buy a $200k home with no mortgage, or the interest alone will pay for most of a studio rental while about $10-15k per person per year continues to go into the bank.

Jack and Jill might have risen to assistant manager by 21 years old and, with no home mortgage, it is affordable to finish the college degree in cash.

There are many ways to reach your goals, as long as you have a good plan.

Landfills see shrinking deposits as the economy declines, because of a “double whammy” of people using things longer before throwing them away and postponing new purchases which means less product packaging in the trash.

Your garbage is your financial planner.

What is your garbage telling you? Is it filled with plastic “clamshells” and Styrofoam padding from all your new toys? Is it filled with single-serving food wrappings or, even worse, bulky prepared-food, disposable containers? How much waste does your garbage audit reveal?

Your mission, should you choose to accept it . . .

You will find that wiser spending correlates with less trash. Several curb-side trash barrels per week could indicate a problem. Aim for one barrel per month.

Everyone should know that trying to save the leftover scraps of a paycheck never works.

Reverse that recipe for failure by 180 degrees.

Plan to save most of your paycheck and leave the leftover scraps for discretionary amusements.

Each transaction can risk a “leak”: In olden days before direct deposit of paychecks, you cashed out each weekly paycheck before depositing anything (sometimes minutes before, sometimes a week before), so there was a risk to hold on to your pay as cash and then fritter away the money. If you visit the ATM more than you visit your family, there is a temptation to round-up your spending “needs” at each ATM visit and then fritter away the overestimate (plus maybe pay fees each time).

The invisible minus: Credit and debit cards are even more tempting to spend than cash because you do not do an actual tit-for-tat physical exchange at the purchase. Instead of having to leave cash behind in the store, you get your card back plus the new stuff.

The solutions are:

Minimize the number of transactions/handling.

Make debits highly visible at the time of purchase and after the spending euphoria fades.

Be creative in how you do these solutions:

Pay cash or record your shrinking account balance at time of purchase.

Post every receipt on the refrigerator (a cluttered refrigerator should tell you something—no, not to buy a bigger fridge).

Get cash once a month for the entire month and seal your weekly gifts to yourself in an envelope.

Saturday, May 5, 2007

Many people misuse "net worth" both on financial blogs and offline. Net worth is a simple snapshot for an immediate liquidation. Positive net worth is "solvent" and negative net worth is "insolvent" (unable to pay all your creditors even if you sold everything immediately). However, most people have no intention to liquidate and misapply the measure for long-term planning. Here are the 3 biggest mistakes that can fool people into false complacency:

Paper Profits: Investments have not made a penny until you cash out the profit ("realize" the gain). The housing bubble is bursting and middle-class people are waking up to find that their houses are worth $100,000 less than they thought. 401k profits are unguaranteed against market losses and uninsured against blatant theft. One 61-year-old woman found that her 401k lost nearly a half-million dollars before she knew it and a fraud victim found a 401k account cleaned out at $0. Social Security is no better, as those periodic statements of future payments include fine print that declares the estimates void of any guarantee, and the government rewrites your fictional “account” balance any time it wants by changing the retirement age or changing the calculation formula.

Real Costs (Present Value, Future Value, and Time Value of Money): Not only is $1 today worth more than $1 tommorrow in a typical inflationary environment, but people forget that different discounts apply to different assets/liabilities. $10,000 in a mutual fund does NOT cancel out $10,000 of credit card debt if the fund earns 11% but your debt costs 13%. Instead, you would lose about $5,000 over 40 years so, if you are trying to measure your long-term financial health, you should discount your mutual fund to $5k or increase the debt value to $15k (I will adress the misuse of tax-deduction modifiers in a future post). Another dangerous ommission is tax liability.

Illiquidity: It is not your money anymore, or not yet, as nowadays so many people sign away rights to their money by chasing tax deductions which restrict access. Whatever money people do not make inaccessible in retirement funds, they trip over themselves to bury in real estate (more on this in a future post).

Phantom Wealth and Broke Millionaires

These factors can result in an alleged paper “millionaire” who cannot make a mortgage or car payment. There are people who complacently carry tens of thousands of dollars of credit card debt because of an imaginary "wealth effect."

As for restricted nanny-state allowances (Social Security, IRA, etc.) and non-money assets (home equity), most people will not convert them into direct buying power until almost 70 years old (relocating home equity from one address to another does not change anything)--and maybe never before they die (when the heirs liquidate the house to pay off the legal, tax, and health-care bills).

Meanwhile, borrowing against assets is a sucker's game.

Resist the urge to borrow against your inaccessible wealth. Paying the interest penalty to borrow against asset value tells you that the asset itself is unavailable, which is why you have to pay someone else to use your own rumored "wealth."

That is quite a trick, being “wealthy” and still having to borrow money. If your "net worth" meant that you actually had money, you could lend to other people and make money by earning interest--instead of losing money by paying interest. Some people pay twice, since they paid an 8% mortgage to "build equity" and then paid another 8% for a home equity loan, which combined is not much different than a 16% credit-card rate. Try defining your wealth by the absence of borrowing.

Wednesday, May 2, 2007

The best way to avoid debt is to question why you are considering debt and reckon your happiness in both the debt and no-debt alternatives.

Let's say you want to buy a $200,000 house. The best method is to pay cash. Who has that kind of money? You do, and more, if you are willing to take a mortgage for it, because you pay the full price plus interest eventually. Right now, setting aside fees, etc. to simplify the example:

Buying a $200,000 house with cash costs you $200,000.

Buying a $200,000 house with a 15-year mortgage costs you $300,000 ($100,000 interest).

Buying a $200,000 house with a 30-year mortgage costs you $440,000 ($240,000 interest; the interest exceeds the house price).

Why would you want to pay $10 for a $5 sandwich, $40,000 for a $20,000 car, or $440,000 for a house that is only worth $200,000?

Joe Consumer orders gadgets online or buys trinkets while traveling to save a few bucks of sales tax but then spends an extra quarter million dollar surcharge (mortgage interest) on the biggest purchase of his life.

Spot logical fallacies. Forget expert recommendations or the plan that "most people" choose. They are not you. Do the numbers make sense for you?

Forget eligibility limits of maximum loans, which are enticements to "overbuy" the lender's product (overborrow). What you could borrow is irrelevant. Stick to what you need and nothing more.

Demand the disclosure of all payments over the lifetime of a loan (avoid the trap of low installments that add up to far greater final cost, especially through negative amortization).

Check the bottom line of total costs, including combined interest rates, fees, surcharges, taxes, or required insurance. A favorite trick is to say things such as "5% more" or "5% over" and people hear "5%" even though the total interest might be 10% or higher.

Question all assumptions (e.g. adjustable rates "estimated" to rise very little). Forget what "probably" will happen according to the optimistic salesperson ("You can always refinance later."). What "could" happen on the downside? Spot oxymoronic, tricky weasel phrases such as, "At worst, it probably won't go higher than . . . ." Probable is not the same as possible.

Review all final written terms at the moment of closing. Do not rely on what the proposal was yesterday and especially do not rely on verbal assurances.

The first thing to do with final papers is to check the last few pages, because a favorite trick is to pack surprises at the end of a stack of papers for when you are tired, bored, running late, and deeply "invested" in a long process (surprisingly, even people who spot a problem will succumb to a "too late" feeling, which of course is the intent of the trick).

Take as much time as necessary to understand the final terms. The rushed sell is one of the oldest tricks so do not be intimidated. A broker in a hurry should have gotten up earlier that day or can return tomorrow. The broker will warn of dire consequences but Rule #1 of business deals is, Be willing to walk away. Feel free to make people wait for your signature--because that quick scribble represents years of your life.

Tuesday, May 1, 2007

People who get themselves into debt problems often do so by wanting to see the best and ignoring red flags so they can sign on the dotted line and get instant stuff.When considering a contract or loan, there is a temptation to ask the right questions but accept dodgy answers that do not add up, so you rationalize that you “did your part” and any later problem will not be your fault.That is a self-deception because you are the one who will be left holding the bag.

Debt Relief: Out of the Frying Pan, into the Fire

People who get themselves in debt trouble are unfortunately likely to repeat the same mistake for the same reason by desperately wanting to believe that some debt-relief expert can provide a painless way out of a debt problem.Some companies charge up-front fees but offer no success guarantee.Some companies offer to take care of everything (sending the mortgage payments, negotiating with banks) but—as you discover too late—did not do so.

You are ultimately responsible and you suffer the consequences so the sooner that you accept responsibility and stop wishing for the too-good-to-be-true short-cut, the sooner you can establish a solid financial foundation.